When businesses come together or when one company acquires another, there's often more to the financial picture than meets the eye. In many cases, a portion of the purchase price is held back in order to guarantee performance and/or retain talent. "Contingent consideration" relates to hold-back payments that are released based on future events or conditions being met, while future compensation arrangements relate to future payments based on continued employment.

Contingent consideration arrangements need to be analyzed carefully to determine if they should be:

1. Included in the consideration transferred for the acquiree (contingent consideration included in purchase price),
2. Accounted for as a separate transaction apart from the business combination (generally recognized compensation cost), or
3. A combination of both.

In addition, how the acquirer accounts for contingent consideration differs depending on whether the transaction is a business combination or an asset acquisition. So, let's break down contingent consideration arrangements and how to account for them in various scenarios.

What is Contingent Consideration?

In its simplest form, contingent consideration, also known as an "earn-out," is a technical term for future payments that might happen based on certain conditions. Think of it like an "if-then" agreement. If a particular condition or event occurs in the future, then a specific amount of money and/or equity is due to the former owners of the acquired company.

For example, say Company A acquires Company B to expand its operations and enter a new market. Company A pays the former owner of Company B $100 million for the company, plus an additional $50 million if, in the next year, Company B increases its net profit by 15%. The additional $50 million payment is contingent consideration.

Contingent Consideration or Compensation Cost?

Both contingent consideration and compensation involve future payments, but they serve different purposes and are accounted for very differently. Here are a few examples of each to help you determine which is which.

Contingent consideration examples:

• A lump sum payment contingent upon the acquirer hitting a net income target
• A series of payments made to the seller once the company reaches a certain percentage increase in revenues
• Payments for reaching non-financial metrics, such as meeting employee or customer retention targets or completing the development of a new product
• Bonus payments paid to key executives who are required to stay on for a specified period after an acquisition
• Bonus or other payments that are forfeited upon termination
• Payments to the seller that are subject to an employment agreement where the period of required employment is as long or longer than the contingent payment period

Future compensation examples:

Some factors to consider when assessing whether a transaction is part of a business combination (purchase price) or is a separate transaction (post-combination compensation expense) are as follows:

• Understanding the Purpose of the Transaction: Gaining insight into the motivations behind a specific transaction or arrangement can shed light on whether it should be considered as part of the overall consideration transferred. For instance, if a transaction primarily serves the interests of the acquiring party or the newly formed entity, rather than benefiting the entity being acquired or its previous owners prior to the combination, that particular portion of the transaction price (along with any associated assets or liabilities) is less likely to be considered part of the exchange for the acquiree. Consequently, the acquirer should account for this portion separately in the context of the business combination.
• Identifying the Initiator of the Transaction: Another key factor to consider is who instigated the transaction. This information can provide insights into whether the transaction is an integral part of the exchange for the acquiree. For instance, if a transaction or event is instigated by the acquirer, it may be aimed at securing future economic benefits primarily for the acquirer or the combined entity, with little or no benefit accrued by the acquiree or its former owners prior to the combination. Conversely, a transaction or arrangement initiated by the acquiree or its former owners is less likely to be geared toward the acquirer's benefit, making it more likely to be considered a part of the business combination.
• Taking Into Account the Timing of the Transaction: The timing of a transaction can also provide valuable insights into whether it is an integral part of the exchange for the acquiree. For instance, a transaction occurring between the acquirer and the acquiree during the negotiation phase of a business combination may have been planned with the intention of securing future economic benefits primarily for the acquirer or the combined entity. In such cases, the acquiree and its former owners before the business combination are likely to receive minimal or no benefit from the transaction, except for any benefits they gain as part of the combined entity.

Contingent Consideration in Business Combinations

In a business combination, contingent consideration is part of the consideration transferred (an unconditional obligation) and, therefore, must be measured and recognized at fair value as of the acquisition date, which can be challenging depending on the nature of the contingency and number of possible outcomes.

Let's consider a couple of examples.

In Scenario 1, Company A's purchase agreement specifies a contingent payment of $50 million to the former owner 12 months after the closing date if Company B increases its net profit by 15%.

In Scenario 2, the purchase agreement requires Company A to pay the former owner of Company B a contingent payment of $50 million if Company B increases its net profit by 15% and the former owner continues his employment for 12 months after the sale.

At first glance, both scenarios might seem to indicate they are contingent consideration. However, in Scenario 1, the future payment amount is conditional and depends on a specific event within a certain period. As a result, Company A records a contingent consideration liability on its balance sheet at fair value on the date of acquisition and then updates the fair value each reporting period through earnings until the contingency is resolved.

On the other hand, in Scenario 2, the amount of the contingent payment depends on reaching the profit target and is conditional on the owner's future employment. Conditional future payments linked to continuing employment should be accounted for as compensation in the acquirer’s post-combination financial statements. The obligation isn’t recorded as part of the purchase price but as a post-acquisition compensation expense.

The classification of contingent consideration as a liability is usually evident when it calls for an acquirer to pay cash or transfer other assets. However, other contingent consideration arrangements may require the acquirer to transfer its own equity (shares of common or preferred stock). Determining the classification of a contingent consideration arrangement that is settleable in stock can be challenging and likely will require you to reach out for help.

The Key Differences in Accounting for Contingent Consideration

To summarize, with any type of earnout or contingent payment, the first step is to determine if it is part of the business combination (recorded as purchase price) or if it is instead a compensation arrangement (recorded as post-combination expense). Next, contingent consideration in a business combination is recorded initially at fair value and is subsequently adjusted up or down over time until settled, affecting the P&L. In an asset acquisition, contingent consideration is recorded when the amounts are paid or become payable and are recognized as a part of the cost of the asset.

Accounting for contingent consideration can seem tricky, but when broken down, it's all about understanding the potential future payments and then determining their value. If you need help with a business combination or an asset acquisition, contact CBIZ ARC. Our professionals have deep accounting and financial reporting knowledge and can provide the technical expertise you need to resolve any accounting issue.

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